(FORTUNE Magazine) – OKAY, Michael Hammer, how do you handle this one? Here's a line of business whose customer base is shrinking. Rivals battle for market share by offering deep discounts. If they hold the line on prices, they risk losing out to cheaper, state-subsidized competitors. Their physical plants are falling apart. They can't fire their highest-paid workers--who put in far less than 40--hour weeks-and federal law says that even the laggards never have to retire. Sound pretty bad?ÊIt gets worse. The CEO isn't free to run the business; he or she needs the workers' approval for most major decisions. The pressures of managing-by-compromise force most bosses to depart within four years. As Thomas Hobbes, the 17th-century English philosopher put it, their lives are nasty, brutish, and short.

Welcome to the byzantine business of higher education. The $180-billion-a-year industry is a textbook candidate for sweeping reengineering, Hammer's specialty. But reshaping companies is Management 101 compared to reforming colleges, a task that requires the equivalent of Ph.D.s in finance, diplomacy, and municipal management. Shielded by a web of laws, traditions, and folkways, colleges have long proceeded at their own rhythms, blithely piling on costs and programs. Productivity, a religion in the boardroom, has been heresy on campus.

Even America's best schools suffer from the college flu, a feverish condition of always spending more than they take in. Presidents get roughed up for merely attempting to balance budgets. Harvard runs a yearly deficit of about $14 million, despite the largest endowment--$6 billion--of any university in the land. At an acrimonious meeting last fall, Harvard faculty members attacked President Neil Rudenstine for failing to adequately consult them about a plan to slightly reduce contributions to their lavish benefits. Shaken, he agreed to consider a counterproposal from the faculty. Two weeks later, Harvard announced that Rudenstine was suffering from exhaustion and would be taking a medical leave. Though he returned to work in February, the benefits issue hangs in limbo. For beleaguered presidents like Rudenstine, life has changed little since Woodrow Wilson, ensnarled in a feud with the faculty, left the presidency of Princeton to become governor of New Jersey in 1910. Wilson is said to have remarked: "I wanted to get out of politics."

Runaway costs--as natural to academe as the ivy--translate into budget-gouging prices for parents. Since 1980, annual tuition at private colleges has jumped from an average of $3,200 to $11,000. In the Ivy League and at prestigious liberal arts institutions, the rise has been far swifter. The official price is $19,900 at Princeton, $19,629 at Williams, and $19,670 at Oberlin. With room and board, the bill goes above $25,000-- only slightly less than the yearly, after-tax income of today's average family.

For consumers, the good news is that most colleges have hit the wall on tuition hikes. A dearth of paying customers and a glut of dormitory beds is turning education into a buyer's market. In 1994, 2.5 million students graduated from high school, vs. three million in 1980. The numbers are starting to rise again. But they hold little comfort for private colleges because over the next decade the biggest increase will come from black and Hispanic students, many of whom attend community colleges.

Only a few elite colleges still fill their classrooms with top students and give financial aid strictly to those who need it. The rest are competing hard for customers who can pay a large part of the bill--and cutting sticker prices to entice them. George Washington University, where the official tuition is $17,500, gives more than half its 5,500 full-time students discounts in the form of cash grants; just five years ago, only one in seven received grants. The money comes in two stages. First, GW automatically awards scholarships to outstanding applicants, regardless of need. The university announces the awards in its acceptance letters, before it has even looked at the parents' financial statements. These scholarships range from about $3,000 for students who score 1200 on their SATs and rank in the top fifth of their class, to $15,000 for National Merit Scholars. For the 1993-94 academic year, GW handed out 379 scholarships averaging $6,000, vs. around 50 in 1989.

Second, students can qualify for additional grants on the basis of need. In the low-savings economy, even affluent families now frequently merit extra money. At George Washington, for example, a family with an annual income of $120,000 and two kids in college could receive $7,000 in need-based grants. On average, GW knocks 39% off the tuition of its students, almost three times the discount of five years ago.

Though George Washington won't match a student's fatter aid offer from another school, many colleges do. "We tell our clients to shop their packages," says Raymond D. Loewe, president of College Money, a New Jersey firm that advises 1,500 families a year on college planning. "Increasingly, it works."

Despite deep discounting, private colleges continue to lose students to public schools, which remain a steal compared to the privates. Consider the rivalry between the University of Rochester and the 17 major campuses of the State University of New York, including Albany, Binghamton, and Geneseo. Measured by average SAT scores, Rochester (1140) and the top SUNYs (1070 to 1150) admit about the same caliber students. Both are successful at placing graduates in jobs or law schools. But the SUNYs charge $2,650 in tuition, vs. $17,800 at Rochester. Beginning next fall, Rochester will give $5,000 grants to in-state freshmen, regardless of need, for each of their four years.

As revenues lag, colleges have no choice but to cut profligate spending. The problem is, they need to invest not less but far more in plant and equipment. Many an ivory tower has cracked and peeled as administrators scrimped on maintenance and new construction to cover rising salaries and benefits. Yale estimates that it will have to spend $1.1 billion to refurbish its leaking dorms and dilapidated classrooms.

That leaves two main candidates for cuts: administrators and faculty. Their combined salaries and benefits account for about 50% of spending at universities with medical schools and research programs; the figure is even higher at liberal arts schools. Although colleges have done noble work downsizing administration, containing the growth in faculty costs has been much harder. The problem is a barrier as hoary and entrenched as the ramparts of a medieval university--tenure.

Except for gross misconduct, colleges can terminate tenured professors only by shutting down a program or declaring a budgetary crisis, a condition called "financial exigency." In February 1994 the board of trustees of St. Bonaventure, a Catholic college in Olean, New York, declared financial exigency. Since then St. Bonaventure has reduced its faculty by 25% and turned a $6 million budget deficit into a $1.2 million surplus. Though tenure isn't always protected by the courts, few presidents dare challenge it. Only one prominent school has abolished it. Last year Bennington College fired 20 tenured professors and placed the remaining faculty on individual contracts ranging from one to seven years.

Tenure has veered from its lofty goal of protecting academic freedom to become lifetime security for a well-paying job. Tenured professors, who earn an average of $60,000 for a nine-month year, typically spend 9.8 to 10.5 hours a week in the classroom and no more than eight hours advising students, according to a study by the Higher Education Research Institute at UCLA. That leaves ample time for the second principal professorial duty: research and writing. But the UCLA study shows that from 1991 to 1993, 41% of America's 536,000 professors published not a single word in professional journals. In the business world, if a product's sales decline, companies lay off some of the people who make it. At a college, tenure makes downsizing all but impossible, except through attrition. During the last decade, subjects like history and classics have lost students to communications and engineering. But short of closing the entire department, colleges can't fire historians or classicists hired in boom times and invest the money in other subjects. The result: Flagging programs stay overstaffed and colleges must hire additional teachers in growing fields. In 1975, Duke had 17 faculty for 130 religion majors; today 16 professors serve 30 majors. At the same time, Duke hired other teachers to expand popular programs like biology.

Outsize faculty costs help explain why even the wealthiest schools are struggling. At Stanford, faculty salaries and benefits are rising 4% a year, almost two points above inflation. Stanford has a model, streamlined administration--and a $3 billion endowment. The problem is that most of the endowment earnings are highly restricted, to be used for scholarships, genetic research, or specific academic programs. This year only $59 million of Stanford's $247 million in gifts and investment income is available for the basic academic budget. Stanford's other major source of revenue--tuition--will grow just 5% this year, vs. 7% in the 1980s and early 1990s. All told, its unrestricted income fell $94.3 million short of expenses from 1991 to 1994, forcing it to spend endowment.

Stanford has begun an ambitious, three-year plan to pull costs in line with revenues. On top of the 20% to 30% cuts it has already made in administrative departments like financial aid and fundraising, it will pare still more jobs. The tight budget leaves little margin for investing in new programs. A primitive system for assigning faculty positions worsens the problem. At Stanford, teaching positions are called billets. Departments developed perpetual property rights to the billets, much as European airlines "own" airport landing slots. When an English professor retired, for example, the department had the right to fill his billet with a new hire. Says Condoleeza Rice, the university's provost: "There was a tendency to replicate the guy who just left, even if his field was moribund."

A lot of Stanford's department heads are quaking under a recent edict that henceforth the administration will control the billets of retiring professors and assign them to subjects that are attracting the most students or that hold high potential. "We'll invest in emerging growth areas," says John Shoven, dean of the school of arts and humanities. Shoven, an economist, has already downsized the languages and classics departments by removing four billets; he created several new positions in a hybrid of anthropology and biology called human evolution. Says Shoven: "I want two startups a year."

Shoven's job would be difficult enough if he were just dealing with faculty members who regard themselves as answerable to no one. But he and other deans also have the federal government to reckon with. In 1982 amendments to the Age Discrimination and Employment Act raised the retirement age for tenured professors to 70; the ceiling was removed entirely in 1994. The legacy is the aging--some would say fossilization--of academe. At Harvard, for example, where the median retirement age is already 68, professors are likely to stay far longer now that there is no cap. "This is a disaster," says Henry Rosovsky, 68, a Harvard economist who intends to leave sooner rather than later. "Professors have so few official duties that it's easy for them to linger, even if they're unproductive."

Replacing older, highly paid faculty with young recruits eases pressures on costs and ensures a steady influx of new scholars with fresh ideas. A 35-year-old teaches at least as many students as a 65-year-old, typically at about half the salary.ÊBut at Harvard, older professorsÊhave a powerful incentive to keep working: The university contributes 11% of salary below $61,200 to the pensions of its professors over the age of 40, and a sumptuous 16% of salary above $61,200. Hence, the plan is disproportionately expensive for older employees. It's not unusual for professors with 30 years' seniority to cash in their pensions for more than $1 million. Harvard projects that if most professors work until age 73-and the benefits system remains unchanged-the aging factor alone will add $13 million a year to its costs by 1998. "We've shed 9% of our administrative workers over the past three years," says Jeremy Knowles, dean of the faculty of arts and sciences. "But that alone doesn't solve the problem of rising personnel costs."

Until recently, state schools coped with financial pressures the same way their private cousins did: by raising tuition. Now state universities are challenging the privates, and each other, by restraining prices. At Michigan State University (enrollment: 40,000), capping tuition is the centerpiece of a daring experiment in productivity. The new president, Peter McPherson, must keep diplomas affordable for his staple customers: smart kids whose parents work on farms or auto assembly lines. Last December he announced that Michigan State would raise tuition no faster than inflation for the next four years, provided the state increases funding at the same modest rate, which is highly probable. Says McPherson: "As parents chase the lowest prices, the cost of education can't keep rising faster than prices and wages."

The Spartan budget used to be anything but. Increasing health care costs--and an overtenured, underworked faculty--had kept costs on automatic pilot. For years, Michigan legislators went along by providing double-digit increases in funding. But since 1991, the state government's appropriations have lagged behind inflation by 5%; they now provide just 52% of Michigan State's budget. Academic spending, on the other hand, has risen 35% since 1988, ten points faster than the CPI--to $447 million. To cover costs, the university has increased tuition 76% since 1988, from $2,500 to $4,400.

Discipline arrived in late 1993 with McPherson, a former executive vice president of Bank of America.ÊHe quickly saved $2 million by privatizing the student bookstore. (He got even more attention when he fired the football coach and put the new man, Nick Saban, on a contract that pays bonuses not just for winning games but for raising his players' grade-point averages.) McPherson is wresting his biggest gains from teaching. Michigan State's 2,038 professors, 207 of whom earn more than $100,000 a year, spend an average of 5.5 hours a week in the classroom. McPherson is pressing them to teach seven hours. Furthermore, he says, "we need research that produces either more revenues or cutting-edge knowledge. Some professors publish a lot, and nobody cares." One way or another, the discipline of the market is coming to campus. "Higher education will be the great restructuring story of the 1990s," says McPherson. Adds Barry Munitz, chancellor of California's state university system: "Trustees and parents are saying, 'We went through it in business. Don't tell us you can't.' " The new order threatens the sacred cows of academia, particularly the power of professors, but it also gives customers more clout. In business, that lowers prices, creates popular new products, and eliminates archaic work rules-not a bad curriculum for the classroom.